Until just recently, I was puzzeled as to why highly intelligent

executives would make substantially "premature" exercises of

their executive stock options and immediately sell the stock.

Although they rarely understand the full nature of ESOs,

executives can afford to hire experts to advise them on

the proper management of their portfolios of employer

securities. No genuine expert would advise executives to make

substantially "premature exercises" of long term ESOs

especially since there are viable hedging strategies available.

The "time premium" forfeited and the current tax liability

incurred upon early exercise are penalties that are necessary

only in rare circumstances.

The risk reduction of diversifying does not justify the

costs of "premature exercises" and sale.

So, is there another reason that executives make "premature

exercises" that is not apparent? The answer is yes.

I call it "disguised re-loading".

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Traditional Re-load provision

In the past, some grants of employee stock options had a

provision that upon exercise and sale of the received stock,

the grantee would automatically receive another load of

employee stock options.

These new options would have the strike price at the

current market and a new ten years of time remaining.

Assume for example the grantee was granted 1,000,000

options to buy stock at 20 for the next 10 years. Assume

that the stock had an expected volatility of .35. Assume

also that the stock advanced to 40 after three years and

the executive exercised his ESOs and sold the stock

received. He would net approximately 60% of the intrinsic

value after tax or about $12,000,000.00.

How much "time premium" would he have forfeited back to

the company? To get the answer we merely calculate the

theoretical value of the ESOs immediately prior to exercise

and subtract the intrinsic value from the theoretical value

The theoretical value is about $25,100,000 with the intrinsic

value of $20,000,000. This makes the forfeited time premium

equal to $5,100,000.

But the re-load feature gives the executive 1,000,000 more

new ESOs with a strike price of 40 with the stock at 40 and

with ten years to expiration day. The question becomes

"what's the value of the new options?".

Well, the theoretical value is $18,000,000.00. That is more

than enough to pay the executive for the forfeited "time

premium" of $5,100,000 plus the tax paid of $8,000,000.

But stockholders have become wary of re-load clauses

because of their abusive characteristics.

Re-load clauses are now rarely part of the options contract.

However, nothing stops the compensation committee from

re-loading the executive with 1,000,000 new ESOs with a

strike price of 40, whether the re-load provision is in the

contract or not.

Accounting Costs

Lets take a look at the accounting costs associated with the

above scenerio. The "Fair Value" of the options granted

with an exercise price and a current market price of 20

is about $9,000,000.00. The "Fair Value" of the options

granted at 40 is $18,000,000.00. So the expenses against

earnings for the grant and the re-load are $27,000,000.00.

The $5,100,000.00 that is forfeited back to the company

is not even considered a reduction of accounting expenses.

Now lets analyze the extra cost to the company of the

"disguised re-load".

It is essentially $13,000,000 since, the $5,100,000 is in

reality forfeited back to the company. But the extra accounting

cost is $18,000,000 because for accounting purposes the

$5,100,000 is not counted.

Compared with Back - Dating

Let's compare this scenario to back-dating of the 1,000,000

shares. Assume that the true market value of the stock

was 30, but the grant day was back-dated to the time

when the stock was 20. Assume the same volatility and

expected time to expiration, (i.e. 35 and 6.3 years).

A) "Fair Value" of the 1,000,000 ESOs with a strike and

market price of 20 is $9,000,000.

B) "Fair Value" of the 1,000,000 ESOs with a strike and

market price of 30 is $13,500,000, making the

difference (i.e. $13,500,000- $9,000,000)= $4,500,000.

C) "Fair Value" of the 1,000,000 ESOs with a strike price of 20

and a market price of the stock of 30 is $16,000,000 making

the difference ($16,000,000 - $9,000,000) = $7,000,000.

This "disguised re-load" in this comparison is 2.00 - 2.8

times more costly to a company in real terms than a very

large case of back-dating.

The cost to the company is 2.6 - 4 times as great in

accounting terms.

"Disguised re-loads" are much more frequent and much more

costly and are therefore much more abusive than back-dating.

This is where the real money is bagged.

Maybe the shareholders will wake up to this scam which is

far bigger than back-dating .

But when these executives add "disguised re-loads" on top of

back dating or spring loading it is easy to see why most of

the company's earnings are going to the executives.

John Olagues

olagues@hotmail.com

 

The author, JOHN OLAGUES, is a former member of the Chicago Board Options Exchange and the Pacific Stock Exchange for over ten years. He offers a unique view of employee stock options from a trader’s standpoint rather than from the standpoint of an accountant, compensation planner or academic. To contact JOHN OLAGUES email olagues@hotmail.com and  see www.optionsforemployees.com.